Containing the Costs of Climate Policy

November 2008

This policy brief outlines various options for containing costs under a cap-and-trade program to reduce greenhouse gas (GHG) emissions. Although cap and trade is generally considered a more cost-effective approach than traditional regulation, excessive allowance prices are a concern, particularly in the early years of a program when some low carbon technologies are not likely to be commercially available. High allowance prices could mean high compliance costs for regulated firms and high energy prices for consumers. A number of the design elements of a cap-and-trade policy—including the stringency of the emission reduction targets and the distribution of allowance value—will influence the cost of the policy. However, uncertainty regarding allowances prices, and in particular short-term price volatility and persistently high prices, are of concern to stakeholders. Policy options to address these concerns include allowing facilities to bank allowances, permitting firms or the government to borrow allowances from future allocations, allowing (or expanding) the use of offsets, allowing the use of multi-year compliance periods, setting a ceiling on allowance prices, or even relaxing the cap or emission targets associated with the policy. Each of these options has strengths and weaknesses and their desired results must often be weighed against the reduced certainty of meeting the environmental objective. A number of these polices, such as banking, could be established as part of the overall policy from the beginning of the program. Others could be set to be triggered automatically if allowance prices reach a certain level or at the discretion of a market oversight entity. It is likely that any viable cap-and-trade proposal will include a variety of cost containment mechanisms.